Should sustainable funds invest in defence assets

Debates around whether or not sustainable investment funds can, or should, invest in the defence sector are high profile at the moment.

This led to the FCA clarifying their position recently – which is essentially that there are no rules on this.  Fund managers can do as they chose.

Having spent a good proportion of my earlier career working with funds that had Quaker and Methodist origins this is something I’ve discussed a great deal… the following are some thoughts on what advisers, portfolio managers and others might like to consider:

Opinions vary about whether or not to invest in defence

Firstly it is important to acknowledge that the world is changing – although opinions do still vary.  Concerns are heightened, as is support for the defence sector. And as defence spending increases it is fair to regard investment opportunities as increasing also. However, we will never all agree, and different people, including fund managers, take different views. Some people will want nothing to do with the area, some people will be enthusiastic supporters of it – and others will be between these two extremes.

• Differences in opinion integral to the need for ESG, responsible, sustainable, and ethical funds. Funds of this kind blend ‘issues’ with maximising ‘financial returns’ in different ways – setting the bar at different levels.
• This ‘area’ evolved to meet the needs of people who want to make money – but not ‘at any cost’. The fact investment strategies vary is a good thing. It reflects the real world.

This points to the need to identify client preferences in this area (in line with Consumer Duty) – so that suitable options are made available – and the risk of awkward questions being asked further down the line is diminished.

Commitments made to clients

The second area to consider is commitments made to clients. Trust is rightly a big deal in investment – so if a product or service has been sold with a particular set of policies managers should think carefully before making changes. Some aspects to consider include:

• if a fund aims to focus on real world sustainability outcomes a client may be baffled if defence companies are held – as alignment to the purpose of the fund (objectives) would be poor.
• if a fund has explicit negative ethical screens, including military exclusions, any shift is unlikely to make sense as outflows and complaints may follow (misalignment would also be an issue here).
• if a fund focuses on ESG risk mitigation shifting a strategy may be more straightforward – as assessment of relevant risks may have changed

Many funds and portfolios are a combination of the above, so in the real world this more complex.

What companies ‘do’ matters

A third area for consideration is what a company, or any other asset, does.  Assets that are commonly excluded sit on the spectrum. Some are more likely to be excluded than others. Examples include:

• companies that supply non military products such as food, clothing or build accommodation to defence companies
• companies that provide safety equipment – some of which may be used by the military
• companies that provide technology or other products that have both military and civilian uses – questions to ask might include:  are products ‘off the shelf’ or ‘bespoke’?  and What proportion of revenue is derived from the defence sector? Are the products used in weapons systems?
• Companies that derive all or most of their revenue from the defence sector – but are not specifically making weapons (eg technology of communications)
• Defence companies – manufacturers or armaments and other products designed entirely for military / defence purposes.

Different funds and portfolios will have different policies for different elements of this chain, and indeed their use of language (eg military vs defence) may also vary.

With regard to the more controversial (latter end of this list) the areas managers are likely to consider, or have concerns about, might include the following:

• Is the company making ‘controversial’ weapons, as articulated in various international agreements? (Some would argue all weapons are controversial – but these are at the top end of this spectrum).
• Who is the company selling to – and who might the weapons be used against?

It is understandably almost impossible to get information on the points above. Defence contractors are not renowned for their transparency – for obvious reasons –  which in ESG circles is a risk. However assessments of this kind are made.

Looking forward

Defence may be a ‘popular’ investment theme today, but things tend to change over time. Investors who set expectations at a given level but do not make their positions sufficiently clear may find themselves vulnerable if an asset they hold falls foul of public opinion further down the line.

There are also many opportunities to invest in defence companies via other options.  Pretending otherwise requires examination of authors’ motivations, in my view.

On a personal note – I find it difficult to square the arguments that there are not enough sustainable investment options to build portfolios – as some claim – with the view that funds in this area are so important that the defence sector may suffer if they don’t invest in their assets.  Neither is true in my opinion. There are many successful sustainable, responsible and ethical fund portfolios, and both matter – but defence spending by government matters far more to defence companies than secondary markets (shares, bonds etc).

Understanding and selecting investment options – using Fund EcoMarket:

Fund EcoMarket filter options can help advisers, wealth managers and portfolio managers respond to their clients different options by enabling users to search the following:

Relevant fund filters (see the Social & Ethical fund filter area).:

• ‘Invests in Gilts ‘government bonds’ (see ‘Gilts & Sovereigns area)
• ‘Gilts / government bonds – exclude some’ (see ‘Gilts & Sovereigns area)
• ‘Gilts / government bonds – exclude all’ (see ‘Gilts & Sovereigns area)
• ‘Armaments manufacturers excluded’ (see ‘Ethical Values led exclusions’ area)

Relevant fund management (company wide strategy) filters (see ‘Responsible ownership – what and how?’ section)

• ‘Controversial Weapons avoidance policy (AFM company wide)’ – (see Company Wide Exclusions area)

As with all filters – if a fund manager has not told us that they explicitly avoid something (eg controversial weapons) it is possible they may (or do) invest in the area.

Additional note: Please be aware that some fund managers are reviewing their strategies in this area. Fund EcoMarket information comes directly from fund managers and is regularly updated however results should be confirmed directly with managers if this is important to a client.

FCA statement link:

https://www.fca.org.uk/news/statements/our-position-sustainability-regulations-and-uk-defence